The Employment number these days is sometimes less interesting than the response of the markets to the number over the ensuing few days. That may or may not be the case here. Thursday’s Employment report was stronger than expected, although right in line with the sorts of numbers we have had, and should expect to have, in the middle of an expansion.
As the chart illustrates, we have been running at about the rate of 200k per month for the last several years, averaged over a full year. I first pointed out last year that this is about the maximum pace our economy is likely to be able to sustain, although in the bubble-fueled expansion of the late 1990s the average got up to around 280k. So Thursday’s 288k is likely to be either revised lower, or followed by some weaker figures going forward, but is fairly unlikely to be followed by stronger numbers.
This is why the lament about the weak job growth is so interesting. It isn’t really very weak at all, historically. It’s merely that people (that is, economists and politicians) were anticipating that the horrible recession would be followed by an awe-inspiring expansion.
The fact that it has not been is itself informative, although you are unlikely to see economists drawing the interesting conclusion here. That’s because they don’t really understand the question, which is “is U.S. growth unit root?” To remember why this really matters, look back at my article from 2010: “The Root of the Problem.” Quoting from that article:
“what is important to understand is this: if economic output is not unit root but is rather trend-stationary, then over time the economy will tend to return to the trend level of output. If economic output is unit root, then a shock to the economy such as we have experienced will not naturally be followed by a return to the prior level of output.”
In other words, if growth is unit root, then we should expect that expansions should be roughly as robust when they follow economic collapses as when they follow mild downturns. And that is exactly what we are seeing in the steady but uninspiring job growth, and the steady if not-unusual return to normalcy in the Unemployment Rate (once we adjust for the participation rate). So, the data seem to suggest that growth is approximately unit root, which matters because among other things it makes any Keynesian prescriptions problematic – if there is no such thing as “trend growth” then the whole notion of an output gap gets weird. A gap? A gap to what?
Now, it is still interesting to look at how markets reacted. Bonds initially sold off, as would be expected if the Fed cared about the Unemployment Rate or the output gap being closed, but then rallied as (presumably) investors discounted the idea that the Federal Reserve is going to move pre-emptively to restrain inflation in this cycle. Equities, on the other hand, had a knee-jerk selloff on that idea (less Fed accommodation) but then rallied the rest of the day on Thursday before retracing a good part of that gain today. It is unclear to me just what news can actually be better than what is already impounded in stock prices. If the answer is “not very darn much,” then the natural reaction should be for the market to tend to react negatively to news even if it continues to drift higher in the absence of news. But that is counterfactual to what happened on Thursday/Monday. I don’t like to read too much into any day’s trading, but that is interesting.
Commodities were roughly unchanged on Thursday, but fell back strongly today. Well, a 1.2% decline in the Bloomberg Commodity Index (formerly the DJ-UBS Commodity Index) isn’t exactly a rout, but since commodities have been slowly rallying for a while this represents the worst selloff since March. The 5-day selloff in commodities, a lusty 2.4%, is the worst since January. Yes, commodities have been rallying, and yet the year-to-date change in the Bloomberg Commodity Index is only 2% more than the rise in M2 over the same period (5.5% versus 3.5%), which means the terribly oversold condition of commodities – especially when compared to other real assets – has only barely begun to be corrected.
I do not really understand why the mild concern over inflation that developed recently after three alarming CPI reports in a row has vanished so suddenly. We can see it in the commodity decline, and the recent rise in implied core inflation that I have documented recently (see “Awareness of Inflation, But No Fear Yet”) has largely reversed: currently, implied 1 year core inflation is only 2.15%, which is lower than current median inflation – implying that the central tendency of inflation will actually decline from current levels.
I don’t see any reason for such sanguinity. Money supply growth remains around 7%, and y/y credit growth is back around 5%. I am not a Keynesian, and I believe that growth doesn’t matter (much) for inflation, but the recent tightening of labor markets should make a Keynesian believe that inflation is closer, not further away! If one is inclined to give credit in advance to the Federal Reserve, and assume that the Committee will move pre-emptively to restrain inflation – and if you are assuming that core inflation will be lower in a year from where it (or median inflation, which is currently a better measure of “core” inflation) is now, you must be assuming preemption – then I suppose you might think that 2.15% core is roughly the right level.
But even there, one would have to assume that policy could affect inflation instantly. Inflation has momentum, and it takes time for policy – even once implemented, of which there is no sign yet – to have an effect on the trajectory of inflation. Maybe there can be an argument that 2-year forward or 3-year forward core inflation might be restrained by a pre-emptive Fed. But I can’t see that argument for year-ahead inflation.
Of course, markets don’t always have to make sense. We have certainly learned this in spades over the last decade! I suppose that saying markets aren’t making a lot of sense right now is merely a headline of the “dog bites man” variety. The real shocker, the “man bites dog” headline, would be if they started making sense again.
In keeping with the topic of the month, I present this chart.
I really wanted to make the x-axis the compounded inflation rate since the World Cup began, but the data is just too difficult to find for many of these countries. Nevertheless, we see the broad outlines of the thesis in this chart. If you want to be excellent at soccer, inflate your economy.
The correlation between soccer wins and inflation (I arbitrarily decided to only include countries which have appeared in eight or more World Cups, so that there is some chance that they have some wins) is only 0.31, but notice the two blue dots at the upper left. I would argue that at least Germany has an inflation-driven history, although since the 1980s they have had fairly low inflation. One might argue the same with Italy, albeit to a lesser extent. If we exclude those two aberrations, the correlation rises to a whopping 0.67!
Ok, sure, this is somewhat spurious – it is largely driven by the fact that two of the winningest teams are Brazil and Argentina, which have quite a history of inflation as well as of soccer. But if the ECB discovers this, it should make sure all of the retail shops in Europe know…and they’ll have widespread support for inflation.
Suddenly, there is a bunch of talk about inflation. From analysts like Grant Williams to media outlets like MarketWatch and the Wall Street Journal (to be sure, the financial media still tell us not to worry about inflation and keep on buying ‘dem stocks, such as Barron’s argues here), and even Wall Street economists like those from Soc Gen and Deutsche Bank…just two name two of many Johnny-come-latelys.
It is a little surprising how rapidly the articles about possibly higher inflation started showing up in the media after we had a bottoming in the core measures. Sure, it was easy to project the bottoming in those core measures if you were paying attention to the base effects and noticing that the measures of central tendency that are more immune to those base effects never decelerated much (see median CPI), but still somehow a lot of people were taken by surprise if the uptick in media stories is any indication.
I actually have an offbeat read of that phenomenon, though. I think that many of these analysts, media outlets, and economists just want to have some record of being on the inflation story at a time they consider early. Interestingly enough, while there is no doubt that the volume of inflation coverage is up in the days since the CPI report, there is still no general alarm. The chart below from Google Trends shows the relative trend in the search term “rising inflation.” It has shown absolutely nothing since the early days of extraordinary central bank intervention.
Now, I don’t really care very much when the fear of inflation broadens. It is the phenomenon of inflation, not the fear of it, which causes the most damage to society. However, there is no doubt that the fear of inflation definitely could cause damage to markets much sooner than inflation itself can. The concern has been rising in narrow pockets of the markets where inflation itself is actually traded, but because we trade headline inflation the information has been obscured. The chart below (source: Enduring Investments) shows the 1-year headline inflation swap, in black, which has risen from about 1.4% to 2.2% since November. But the green line shows the implied core inflation extracted from those swap quotes, and that line has risen from 1.2% in December to 2.6% or so now. That is far more significant – 2.6% core inflation over the next year would mean core PCE would exceed 2% by next spring. This is a very reasonable expectation, but as I said it is still only a narrow part of the market that is willing to bet that way.
If I was long equities – which I am not, as our four-asset-class model currently has only a 7.4% weight in stocks – then I would keep an eye on the search terms and for other anecdotal evidence that inflation fears are starting to actually rise among investors, rather than just being the probably-cynical musings of people who don’t want to be seen as having missed the signs (even if they don’t really believe it).
As we wait to see whether the Fed slants its statement ever-so-slightly to the hawkish side or ever-so-slightly to the dovish side (not to mention whether Chairman Yellen repeats her blunt performance in the presser), it is probably worth a few moments to think about what the Fed ought to do.
Yesterday’s inflation figures, viewed in isolation, might be perceived as a one-off bad figure. I pointed out yesterday some reasons that this would be an unfortunate error. Keep in mind that anything the Fed does to address monetary policy will take some time to impact an economic process with momentum. That is to say that even if the Fed tightened today, core inflation over 3% is probably still going to happen. The real question is how high inflation goes, and how long it stays there. There is no longer any question about whether inflation is rising. (This has actually been true for a while, but people who were focused on core rather than median and didn’t look at the particulars of inflation, as well as those who focus on the “output gap” as preventing any possibility of inflation, have been able to ignore the signs for a while).
As an aside, the “output gap” crowd – who expected deflation in 2009-10, and didn’t get it, and now expect disinflation, but aren’t getting it – aren’t defeated yet. They’ll simply re-define the gap to fit the data, I am sure. When you get to choose your own observations and change the model to fit the observations, science is easy.
What concerns me about the Fed’s next steps here, and the state of the debate, is that the Federal Reserve seems overly focused on the level of interest rates, and how to adjust them, and not on the level of reserves or controlling the transactional money supply. For example, recently the IMF published a paper arguing that central banks should raise the long-term inflation target from 2% to 4% because with a 2% target it is too easy to get deflation and have interest rates pinned at zero, leaving the central bank powerless to stop deflation. It seems not to matter to the author that Japan only recently proved that it is money, and not interest rates, that matter when they were able to get out of deflation with an aggressive QE. And, after all, “Helicopter” Ben made the point years ago that deflation is easy to prevent if only the Fed prints money.
So the cult of interest rate manipulation concerns me. Another, and more influential, example (because after all, no one really believes the central bank will start targeting 4% inflation) is in the publication recently of “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve,” co-authored by Brian Sack and Joseph Gagnon. Dr. Sack used to be head of the Fed’s Open Markets Desk, so his opinions have some weight in the institution. In this policy brief, he and his co-author suggest ways that the Fed could raise rates even without reducing the amount of excess reserves in the system. Their approach would, indeed, succeed in moving interest rates. But the proposal, in the authors’ words, “appropriately ignores the quantity of money.”
Considering that it is the quantity of money, not its price, that impacts inflation – as hundreds of years of monetary history have proven beyond any educated doubt – this is a frightening view. We are always looking for where the next policy error will come from; this is certainly a strong candidate.
There is a crucial misunderstanding here, and it is unfortunately a fundamental tenet of the interest rate cult. Interest rates are not the cause of money supply changes, but the result of them. The way the Fed operates tends to cause this confusion, because the Fed seems to adjust interest rates. But that is not in fact what happens. The Desk actually adjusts the level of reserves in the system, and reads the interest rate as an indication of whether reserves are at the right level (or at least, this was the way it used to be done, before the “environment of abundant liquidity”). The confusion has gradually developed, and the institution has contributed to the confusion by gradually altering its policy statements to obfuscate what is actually going on. The domestic policy directive of February 1989 said in part:
“In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions…somewhat greater reserve restraint would, or slightly lesser reserve restraint might, be acceptable in the intermeeting period. The contemplated reserve conditions are expected to be consistent with growth of M2 and M3 over the period from December through March at annual rates of about 2 and 3½ percent, respectively.”
Notice that the main focus here is how pressure on reserves leads to money supply growth. By 1994, the Fed was drawing the line to interest rates more explicitly. The press release following the February 4th, 1994 meeting said in part:
“Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short-term money market interest rates.”
The Federal Reserve eventually stopped talking about “reserve positions,” although that continued to be how interest rates were managed in fact. Here is what the Fed was saying in January 2007:
“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.”
Now, of course, the Fed not only sets the current level of interest rates but also gives us an expected path.
But again, even when the Fed was talking about the interest rate target, the Fed actually managed interest rates by managing reserves. By doing large system repos or matched sales, the supply of reserves was managed with respect to what the Fed thought the demand for reserves (which is unobservable in real time) was. If the resulting interest rate was too low or too high, then they added or subtracted to the supply reserves. And thus we get to the point that is crucial for understanding how monetary policy is conducted: the interest rate is a measurement of the pressure on reserves.
Interest rates, in other words, are like a thermometer that measures the temperature in the body. The doctor plies his trade on a feverish patient with an eye on the thermometer. He can’t see the microbes and antibodies, but the thermometer tells him (her) if he (she) is winning. In exactly the same way, the level of short-term interest rates tells the Fed if they have too many reserves or too few. But suppose the doctor lost sight of the real purpose of treatment? Suppose the doctor said “wow, this would be so much easier if I just put a little dial on the thermometer so that I could control the reading directly! Then I could just set it to the right temperature and I would be done.” We would all recognize that doctor as a quack, and the patient would probably die.
This approach, though, is what the Sack/Gagnon paper proposes. We want to control the temperature, so let’s introduce a thermometer that allows us to control the temperature! But this is wrong, because it is the reserve position that is critical to control; it is that which is out of control at the moment due to the presence of copious excess reserves; and the fact that the Fed can simply set the interest rate is irrelevant. (Why do we need a Fed? Why not have Congress set the legal interest rate at the “appropriate level” so that the Fed doesn’t even need to do open market operations?)
The Sack/Gagnon plan will clearly permit the movement of interest rates to wherever the Fed wants them to be. But it will not solve the root problem, which is that the level of required reserves is essentially out of the Fed’s control – which means the size of the money supply is out of its control as well. Excess reserves will continue to leak into transactional money, and inflation will continue to rise. Here is your error. The Fed is about to score an “own goal.”
As expected, and as I’ve been saying for a long time, (a) median inflation is rising and now is at 2.3% y/y, the highest level since 2009, and (b) core inflation is converging to median inflation as the one-off effects of the sequester on Medicare payments is removed from the data.
Following is a summary of my post-CPI tweets. You can follow me @inflation_guy!
- Well, I hate to say I told you so, but…increase in core CPI biggest since Aug 2011. +0.3%, y/y up to 2.0% from 1.8%.
- Let the economist ***-covering begin.
- Core services +2.7%, core goods still -0.2%. In other words, plenty of room for core to continue to rise as core goods mean-reverts.
- (RT from Bloomberg Markets): Consumer Price Inflation By Category http://read.bi/U60bLJ pic.twitter.com/R2ufMjVRRM
- Major groups accel: Food/Bev, Housing, Apparel, Transp, Med Care, Other (87.1%) Decel: Recreation (5.8%) Unch: Educ/Comm (7.1%)
- w/i housing, OER only ticked up slightly, same with primary rents. But lodging away from home soared.
- y/y core was 1.956% to 3 decimals, so it only just barely rounded higher. m/m was 0.258%, also just rounding up.
- OER at 2.64% y/y is lagging behind my model again. Should be at 3% by year-end.
- Fully 70% of lower-level categories in the CPI accelerated last month. That’s actually UP from April’s very broad acceleration.
- That acceleration breadth is one of the things that told you this month we wouldn’t retrace. This looks more like an inflation process.
- 63% of categories are seeing price increases more than 2%. Half are rising faster than 2.5%.
- Back of the envelope says Median CPI ought to accelerate again from 2.2%. But the Cleveland Fed doesn’t do it the same way I do.
- All 5 major subcomponents of Medical Care accelerated. Drugs 2.7% from 1.7%, equip -0.6% from -1.4%, prof svs 1.9% from 1.5%>>>
- >>>Hospital & related svcs 5.8% from 5.5%, and Health insurance to -0.1% from -0.2%. Of course this is expected base effects.
- Always funny that Educ & Communication are together as they have nothing in common. Educ 3.4% from 3.3%; Comm -0.24% from -0.18%.
This was potentially a watershed CPI report. There are several things that will tend to reduce the sense of alarm in official (and unofficial) circles, however. The overall level of core CPI, only just reaching 2%, will mean that this report generates less alarm than if the same report had happened with core at 2.5% or 3%. But that’s a mistake, since core CPI is only as low as 2% because of one-off effects – the same one-off effects I have been talking about for a year, and which virtually guaranteed that core CPI would rise this year toward Median CPI. Median CPI is at 2.2% (for April; it will likely be at least 2.3% y/y from this month but the report isn’t out until mid-day-ish). I continue to think that core and median CPI are making a run at 3% this calendar year.
The fact that OER and Primary Rents didn’t accelerate, combined with the fact that the housing market appears to be softening, will also reduce policymaker palpitations. But this too is wrong – although housing activity is softening, housing prices are only softening at the margin so far. Central bankers will make the error, as they so often do, of thinking about the microeconomic fact that diminishing demand should lower market-clearing prices. That is only true, sadly, if the value of the pricing unit is not changing. Relative prices in housing can ebb, but as long as there is too much money, housing prices will continue to rise. Remember, the spike in housing prices began with a huge overhang of supply…something else that the simple microeconomic model says shouldn’t happen!
Policymakers will be pleased that inflation expectations remain “contained,” meaning that breakevens and inflation swaps are not rising rapidly (although they are up somewhat today, as one would expect). Even this, though, is somewhat of an illusion. Inflation swaps and breakevens measure headline inflation expectations, but under the surface expectations for core inflation are rising. The chart below shows a time-series of 1-year (black) and 5-year (green) expectations for core inflation, extracted from inflation markets. Year-ahead core CPI expectations have risen from 1.7% to 2.2% in just the last two and a half months, while 5-year core inflation expectations are back to 2.4% (and will be above it today). This is not panic territory, and in any event I don’t believe inflation expectations really anchor inflation, but it is moving in the “wrong” direction.
But the biggest red flag in all of this is not the size of the increase, and not even the fact that the monthly acceleration has increased for three months in a row while economists keep looking for mean-reversion (which we are getting, but they just have the wrong mean). The biggest red flag is the diffusion of inflation accelerations across big swaths of products and services. Always before there have been a few categories leading the way. When those categories were very large, like Housing, it helped to forecast inflation – well, it helped some of us – but it wasn’t as alarming. Inflation is a process by which the general price level increases, though, and that means that in an inflationary episode we should see most prices rising, and we should see those increases accelerating across many categories. That is exactly what we are seeing now.
In my mind, this is the worst inflation report in years, largely because there aren’t just one or two things to pin it on. Many prices are going up.
The recent, aggressive ECB ease, combined with some mild Fed growls about increasing rates “at some point,” ought to be good news for the dollar against the Euro. And so it has been, although as you see in this weekly chart (source: Bloomberg) the weakening of the Euro has been (a) mild and (b) started more than a month before the ECB actually took action. (Note that the units here are dollars per Euro).
Even though the ECB did considerably more than expected, much of that was in the form of a promise; until the body takes concrete steps towards implementing some of the new QE forms, the decline in the Euro is likely to be relatively slow and steady. Similarly, although the Yen has stopped weakening in 2014, I expect that trend has further to go as long as the Bank of Japan doesn’t lose its nerve with easing. In any event, both of those central banks seem at the moment to be more dovish than the Fed, which augurs for dollar strength.
Is that bad for commodities? The conventional wisdom is that since many commodities trade in dollars, a strong dollar implies weak commodities and vice versa.
There is some support for this view. The chart below (source: Bloomberg) shows weekly levels of the dollar index versus the DJ-UBS index, going back to 1996 or so. The correlation is okay, at -0.725.
Note, though, that this is a correlation of levels. If you look at a correlation of changes, which is what you would need to use dollar movements as a trading model for commodities, it is effectively zero. (These two series aren’t lovers, moving together always, but just friends coming together to the same place from time to time). Moreover, the regression of levels says that commodities are currently 15% or so cheap – the red smudge on the chart shows the current levels (yet another way that commodities appear to be cheap). Finally, the beta is quite low: if the dollar index rose 20%, it would correlate with roughly a 20% decline in commodities…if commodities preserved the same level of cheapness. To be sure, that is a sizeable drop but a 20% rise in the dollar would put it at levels not seen in more than a decade.
In any event, be careful not to confuse the nominal dollar price of commodities with the real price (I’ve made this argument from time to time in many contexts – see for example here, here, and here). Although changing the value of the dollar will diminish the price of commodities in dollars relative to what they would otherwise would be, if the global price level rises then the price of commodities will rise with it – they just may rise less than they otherwise would. And, since commodities typically experience their highest inflation “beta” at the beginning of an increase in inflation, it is reasonable to expect that commodities’ rise will be enough to cause any dollar-inspired softness to be completely obscured.
You still want to be long commodities if we are in an inflationary upswing, regardless of what the Fed does. And, needless to say, I am somewhat skeptical that the Fed will do anything particularly aggressive on the tightening side!